Use Scrutiny When Vetting the Franchisor

Posted by Jeremy BraschMay 25, 20180 Comments

Franchise Vetting

As a franchise-attorney and former franchisee, I know the significance of buying a franchise.  For most, it is the single biggest investment of a lifetime.  

Considering the magnitude of the investment, the amount of pre-purchase due diligence should equal the financial investment. Franchise Vetting is hard work.  It takes a lot of time and effort.  But franchise vetting is critical if you hope to be happy and successful. Franchise vetting involves closely examining the whole franchise system.  When buying a franchise, my experience suggests some of the most important considerations are:

Territorial Rights – Who's Knocking On Your Door?

1. Internal vs External Competition: In the franchise, world competition exists internally and externally.  External competition is every business taking market share and revenue away from you.  Internal competition exists among other franchisees within the same franchise system.            

Analyze internal competition by looking at your applicable territory.  The territory in which the franchisee is located in the relevant consideration. Other franchises are not internally competitive if located in a different territory, far away.

It is a delicate balance, but internal competition can actually be a good thing.  Having other franchisees in your market strengthens the franchise brand.  If your brand is underrepresented in the market then it can be bad for business; customers simply won't think about you.

On the other hand, too great a presence of internal competition causes cannibalism.  Potential customers can be pilfered by “friendly” competition.     

2. Territory, as Viewed by the Franchisor: It is an understatement to say that franchise systems view territory differently. The world is huge in this regard.  Some systems sell geographical rights, awarding exclusive territories.  Other franchise systems offer little in the way of protection from internal competition.  In this context, franchise vetting means understanding the scope of protection afforded by the franchisor in your territory.

Exclusive territories offer the greatest level of protection.  An exclusive territory belongs solely to the franchisee; the franchisee owns the whole market.  As a franchise attorney, I prefer this for my clients since it precludes internal competition.  However, an exclusive territory does not come free; it is can be costly and is usually accompanied by development deadlines (development schedules can create other issues too large to discuss in this article). 

A lack of an exclusive territory is not necessarily problematic.  Depending upon the franchise model, it might not even make sense. The real issue comes when territorial rights are vaguely expressed.  As a franchise attorney, vague territory descriptions frighten me because proper due diligence is impossible and the terms are difficult to enforce (leaving more room for litigation).  In this sense, franchise vetting means having clarity on the terms, regardless of territory protection – the terms must be clearly stated.

Another problem I frequently observe is a “trust me” approach to territory.  Franchisors using a “trust me” approach attempt to alleviate concerns by issuing assurances (e.g. “we would never do anything to harm your business”).  But assurances can be difficult to enforce – if not impossible – and ultimately offer little protection.   

My advice is to proceed with caution if territorial rights are not clearly expressed.  If exclusive territories are used, then the boundaries should be clearly defined.  Well-defined boundaries are enforceable.  On the contrary, if exclusive territories are not utilized then there should be a clear understanding of the protection that exists – if any.  For example: “how close can another franchisee locate?” and “in what areas can a franchisee advertise?”.  The goal is to eliminate ambiguity and to have a clear understanding.

Litigation History – Who Sued Whom & Why?

Litigation history is really important to analyze because it is an indicator of the franchisor-franchisee relationship.  Past litigation is provided by the franchisor in the disclosure documents before the prospective franchisee is bound.  This allows for review prior to committing to a franchise.

Litigation history tells a story.  Since we live in a litigious society, lawsuits are frequently filed.  Therefore, no franchisor is litigation-blemish-free.  However, the litigation history can tell a lot about the franchisor.  A franchisor with a history of lawsuits against franchisees may suggest a strong-handed totalitarian form of governance. Prospective franchisees should be wary of engaging with overly litigious franchisors.  Ideally, franchisors should collaborate with franchisees to solve problems, rather than use them to enforce the oppressive rule.

When franchise vetting the litigation history, the analysis should consider who initiated the majority of the lawsuits – was it the franchisor or different franchisees. Concurrently, the litigation timeline should be evaluated:  ask, “when did the majority of the lawsuits occur?” and “is there a pattern?”.  If there is a pattern – a cluster of litigation – then perhaps this is due to a policy enacted by the franchisor.  Dig down and learn what caused the rash of lawsuits.  History can, and often does, repeat itself.

Talk with Owners – Get to Know the Internal Competition

Franchise vetting includes speaking with current franchise owners.  If you do not speak with other franchisees before buying a franchise, then you have not done your homework – simple as that.

By speaking with other owners, you can gain an honest perspective and insight into the brand.  Talk with owners in different geographical markets; learn issues faced elsewhere.  Talk with owners in your market to learn about issues applicable to you.  Speak with owners of different sizes, meaning single-unit owners or multi-unit ownership groups. 

The crux is to speak with franchisees having different perspectives.  By so doing, you will gain a fuller understanding of the franchise system. 

Talk with Former Owners – Why Did You Leave (and Was the Grass Really Greener)?

A logical corollary to speaking with current franchisees is to speak with former franchisees.  Former franchisees are not always disgruntled.  Business people redeploy assets; it is part of the business cycle.  Therefore, you may gain insight from someone with a positive experience.

However, you might get some of the dirt!  Former franchisees might be angry and have had bad experiences.  Feedback of this sort should be welcomed by a prospective franchisee practicing due diligence.  As a prospective franchisee you are not yet bound, so take the golden opportunity to learn: the good, the bad, and the not-so-beautiful details.

Age of the Franchise – New Kid in Town? Long-standing?

Age is not dispositive of success.  The business market changes every day and franchises must evolve.  Therefore, a young franchise could be ready to explode onto the scene, while an older brand could fade into oblivion.  Franchise systems young and old offer advantages and disadvantages.   

1. Franchise Systems with a History

Think about the different franchise brands that you've witnessed being in business for decades.  Over the years, those brands have faced many different challenges and have adapted in order to survive.  Buying a long-standing franchise suggests that success will be continued.

However, buying an established franchise does not guarantee success.  The brand must continue to overcome new challenges.  For the prospective franchisees, there are many challenges faced. Growth opportunities may be limited in your market.  Many established brands have reached saturation levels of precluding growth.  Therefore, a prospective franchisee might literally be unable to enter the brand in a given area.

Another common problem with long-standing brands is inflexibility, particularly when negotiating the franchise agreement.  The franchise agreement is unique to the franchisee and is the contract that governs and binds the franchisor-franchisee relationship.  Longstanding franchisors are often difficult to negotiate with.  The franchisee can be stuck with a take it or leave it to contract “negotiation”.

2. Young Franchise Systems

Despite lacking a history of success, young franchise systems can offer advantages over long-standing franchises.  Lacking the leverage of their senior counterparts, young franchise systems are generally receptive to feedback and flexible in negotiation, which can be a huge advantage to the franchisee.  But a word of caution – if a brand is overly willing to negotiate changes to the franchise agreement it could be problematic, suggesting a possible lack of uniformity throughout the franchise system (a franchise system must be consistent).

Growth opportunities can be another advantage with young franchises. Large markets exist without the franchise's presence.  Therefore a motivated franchisee could gobble up huge swaths of territory. 

There are downsides to buying into new franchise systems. The lack of demonstrable success is the primary issue.  Franchise Vetting means also investigating the logistical capacities (e.g. product supply chains, adequate training programs, etc.), and brand equity (i.e. the consumer's knowledge and excitement about a brand relative to a specific market). 

Everything in business is a give and take.  Long-standing franchise systems offer advantages over their younger counterparts, yet young franchise systems can be appealing for different reasons.  The key for the prospective franchisee is to vet the differently aged franchise systems in order to find the right fit.    

Leadership Team – Who's at the Helm?

The leadership of a business is important because it directs the ship.  As a franchisee, you're in an interesting position: part employer, part employee.  You make the rules and yet are still subject to those above.  Therefore, the franchise leadership team is critical.

Start by looking at the resumes of the leadership team.  Is the leadership team comprised of people with a history of successful franchise management?  Leaders lacking outside experience might struggle to tackle new challenges the franchise faces. Be cautious about organizational leadership that is comprised of individuals without external experience.  At least some members of the leadership team should have a resume of successful leadership with other organizations.  A leadership team should be comprised of people with differing opinions.  A common resume can lead to common thought devoid of creativity and individual opinion.

Another important consideration is the duration of the leader's former places of employment. Examine the duration of the leader's former tenures and consider the likelihood of their staying with your prospective brand.   

Franchise vetting is a must before entering into a contract.  It is absolutely critical for the prospective franchisee to spend time in due diligence combing through the details.  Seek the advice of franchise professionals to help with the process. Invest in your future and take time to learn about the franchise.